Saturday, October 09, 2004
Market Update
Group-think May Be Present in Bear Camp
In case the title of this email confuses you, let me reassure that I am still firmly entrenched in the BEAR CAMP as far as my long-term outlook for the US equity market is concerned. I still believe that the excesses of the late 1990's bubble has not been washed away, but in fact exacerbated by loose monetary policies, a corrupt corporate culture, and historical levels of debt accumulated over the past four years. In addition, I believe that a lopsided global economy will soon have to come face-to-face with ever mounting imbalances in the form of runaway current account deficits in the US, an overheated Chinese economy still rigged with bad bank loans, industrial overcapacity and increasing inflationary pressures, and the lack of an autonomous source of domestic demand in much of Asia and Europe. To top it off, I believe US equities are still valued above the average historical norms, and coupled with lingering structural overcapacity and weakening end-demand in the face of globalization and a rising interest rate environment, my opinion is that there is still much work to do on the downside. Looking further ahead into the decade and beyond, we also have massive demographic pressures bearing down on the economy, not to mention the timebomb ticking away in Social Security.
Capital markets history tells us quite clearly that we are in a secular bear market that may last 8-20 years. My opinion is that this bear market will be made worse by the macroeconomic imbalances and the demographic pressures mentioned above. We are going to be in a long investment winter.
But that is for the long term. It is true that in shorter time frames, trading opportunities may develop that run either with the long-term trend (that is, DOWN), or against the long-term trend. The bull cycle from March 2003 to January 2004, for instance, represented a trading opportunity that offered fat profits for all those who were courageous enough to take the long side. Presently we are in a multi-month downtrend and appear to be trying (albeit a bit unsuccessfully) to break out of a declining trendline. Whether we will break out to fresh yearly highs or break down to new yearly lows is the consideration of technical analysis, NOT fundamental analysis. Fundamental analysis tells us we are in a secular bear market. But we need more powerful tools if we wish to game the next swing correctly to the upside or to the downside. In a secular bull market, even a financially illiterate fool can make money by simply buying and holding. But in a secular bear market, it is the swing trader, not the buy-and-hold investor, who will bring home the bacon.
Even though I am firmly grounded in the bear camp, I am nontheless aware that the bear camp is increasingly becoming dominated by a group-think mentality, in which analysts tune in specifically to bear arguments and fail to consider other points of view adequately. In reality, there are many folks out there who only look out for material that back their own viewpoints, with little regard to either the accuracy of the material being considered or whether there are other facts or issues involved that may warrant a reinterpretation of their standpoints.
This issue about a group-think mentality pervading in the bear camp was recently highlighted and brought out into the open for all to see, courtesy of an article by Bill Gross, the King of Bonds (and Chief Investment Officer at PIMCO), coupled with the rebuttal put forward by Fed Governer John Berry in a Bloomberg column. Basically, Gross alleges that the CPI calculated by the government understates inflation and this is robbing TIPS holders and pensioners of their deserved annual benefits. Now, I am actually in agreement with Bill Gross on this score. I think that the CPI understates inflation by as much as 2%, or a full 200 basis points, and that the true rate of inflation is somewhere in the region 3.5%-4.5% per annum.
Essentially, Gross believes that the CPI understates inflation because of:
(a) hedonic adjustments (which moderates a product's contribution to inflation by taking into account quality improvements over the years --- think about say, upgrading from a P1 Pentium to a 2GHz AMD processor but paying only slightly more);
(b) substitution biases (which takes into account changing consumer preferences as related to price changes --- think for example preferring a Big Mac to a Quarter Pounder)
(c) an overemphasis on core inflation (which excludes food and energy)
Now, virtually every bear out there (up to and including yours truly) believes that hedonic adjustments and substitution biases DO INDEED lead to a CPI that understates the true rate of inflation. Most of us take it at face value without delving too deeply into the calculations, though I must point out there are a few very sophisticated folks out there who know their homework and who back up this point of view.
However, I am nevertheless surprised that Fed Governer John Berry's rebuttals have been easily dismissed without any analysis by the bear community. To my surprise, when I read Berry's counterarguments, I found that he had made quite a number of cogent and well thought-out points --- things that deserve a closer look by any bear who is serious about shaping accurate views about CPI and inflation. For example, Berry points out that owner's equivalent rent and apparel account of a very large part of the hedonic adjustments, and these items actually push the CPI up rather than down. By contrast, computers and electronic equipment, which are most readily used by the bears to argue against the accuracy of the CPI, account for only a small part of the CPI by weight. In addition, Greenspan and company have frequently spoke about the risks posed by rising oil prices, contrary to belief that oil prices are not cared about.
It is true that Berry's rebuttals are not perfect and one can make out a point-by-point counter to them. However it is quite amazing that these points have gone relatively unnoticed by bears over all these years, and anyone who has done their homework properly should have observed them long ago. This suggests to me the presence of a group-think mentality in the bear camp.
But group-think or no group-think, I am persistent in my belief that we are in a multi-decade secular bear market which should see the 20-year T-bill outperform stocks on a risk-adjusted basis. Longer term, the better investment opportunities are to be found in Asia and in emerging markets, with special focus on economies like India, Malaysia, Thailand and the Philippines. Investors should also presently overweight European and Asian debt instruments of higher grade and shorter duration, and switch again into emerging market debt only after the next recession has played itself out.
In the short run, the US market is reaching an overbought level and intermediate-term indicators have either already peaked out or are showing definite signs of peaking out. However, sentiment is still not excessively bullish even though we are right now inching towards that direction, day by day. (Remember that sentiment indicators are contrarian indicators, so we interprete a bullish sentiment reading as actually being bearish for the market, and vice-versa.) As such if we begin to decline from here, it would not be a severe decline. On the other hand, a good rally that sends the short and medium-term indicators to maximum overbought levels and which also sends sentiment to excessively bullish levels would represent a terrific shorting opportunity. My technical update will spell out the situation in greater detail.
TRADING STRATEGY: Remain neutral until further developments. Short the market on excessive bullishness, in particular, if the S&P re-captures 1140 and sends the 10-day moving average of the CBOE put/call ratio below 0.80.
INVESTMENT STRATEGY: Overweight bonds and underweight stocks in general. Within bonds, overweight short duration investment-grade bonds. Within stocks, overweight Asia. Be prepared to change to 100% bonds upon signal of the next recession (due 2005-2006).
Group-think May Be Present in Bear Camp
In case the title of this email confuses you, let me reassure that I am still firmly entrenched in the BEAR CAMP as far as my long-term outlook for the US equity market is concerned. I still believe that the excesses of the late 1990's bubble has not been washed away, but in fact exacerbated by loose monetary policies, a corrupt corporate culture, and historical levels of debt accumulated over the past four years. In addition, I believe that a lopsided global economy will soon have to come face-to-face with ever mounting imbalances in the form of runaway current account deficits in the US, an overheated Chinese economy still rigged with bad bank loans, industrial overcapacity and increasing inflationary pressures, and the lack of an autonomous source of domestic demand in much of Asia and Europe. To top it off, I believe US equities are still valued above the average historical norms, and coupled with lingering structural overcapacity and weakening end-demand in the face of globalization and a rising interest rate environment, my opinion is that there is still much work to do on the downside. Looking further ahead into the decade and beyond, we also have massive demographic pressures bearing down on the economy, not to mention the timebomb ticking away in Social Security.
Capital markets history tells us quite clearly that we are in a secular bear market that may last 8-20 years. My opinion is that this bear market will be made worse by the macroeconomic imbalances and the demographic pressures mentioned above. We are going to be in a long investment winter.
But that is for the long term. It is true that in shorter time frames, trading opportunities may develop that run either with the long-term trend (that is, DOWN), or against the long-term trend. The bull cycle from March 2003 to January 2004, for instance, represented a trading opportunity that offered fat profits for all those who were courageous enough to take the long side. Presently we are in a multi-month downtrend and appear to be trying (albeit a bit unsuccessfully) to break out of a declining trendline. Whether we will break out to fresh yearly highs or break down to new yearly lows is the consideration of technical analysis, NOT fundamental analysis. Fundamental analysis tells us we are in a secular bear market. But we need more powerful tools if we wish to game the next swing correctly to the upside or to the downside. In a secular bull market, even a financially illiterate fool can make money by simply buying and holding. But in a secular bear market, it is the swing trader, not the buy-and-hold investor, who will bring home the bacon.
Even though I am firmly grounded in the bear camp, I am nontheless aware that the bear camp is increasingly becoming dominated by a group-think mentality, in which analysts tune in specifically to bear arguments and fail to consider other points of view adequately. In reality, there are many folks out there who only look out for material that back their own viewpoints, with little regard to either the accuracy of the material being considered or whether there are other facts or issues involved that may warrant a reinterpretation of their standpoints.
This issue about a group-think mentality pervading in the bear camp was recently highlighted and brought out into the open for all to see, courtesy of an article by Bill Gross, the King of Bonds (and Chief Investment Officer at PIMCO), coupled with the rebuttal put forward by Fed Governer John Berry in a Bloomberg column. Basically, Gross alleges that the CPI calculated by the government understates inflation and this is robbing TIPS holders and pensioners of their deserved annual benefits. Now, I am actually in agreement with Bill Gross on this score. I think that the CPI understates inflation by as much as 2%, or a full 200 basis points, and that the true rate of inflation is somewhere in the region 3.5%-4.5% per annum.
Essentially, Gross believes that the CPI understates inflation because of:
(a) hedonic adjustments (which moderates a product's contribution to inflation by taking into account quality improvements over the years --- think about say, upgrading from a P1 Pentium to a 2GHz AMD processor but paying only slightly more);
(b) substitution biases (which takes into account changing consumer preferences as related to price changes --- think for example preferring a Big Mac to a Quarter Pounder)
(c) an overemphasis on core inflation (which excludes food and energy)
Now, virtually every bear out there (up to and including yours truly) believes that hedonic adjustments and substitution biases DO INDEED lead to a CPI that understates the true rate of inflation. Most of us take it at face value without delving too deeply into the calculations, though I must point out there are a few very sophisticated folks out there who know their homework and who back up this point of view.
However, I am nevertheless surprised that Fed Governer John Berry's rebuttals have been easily dismissed without any analysis by the bear community. To my surprise, when I read Berry's counterarguments, I found that he had made quite a number of cogent and well thought-out points --- things that deserve a closer look by any bear who is serious about shaping accurate views about CPI and inflation. For example, Berry points out that owner's equivalent rent and apparel account of a very large part of the hedonic adjustments, and these items actually push the CPI up rather than down. By contrast, computers and electronic equipment, which are most readily used by the bears to argue against the accuracy of the CPI, account for only a small part of the CPI by weight. In addition, Greenspan and company have frequently spoke about the risks posed by rising oil prices, contrary to belief that oil prices are not cared about.
It is true that Berry's rebuttals are not perfect and one can make out a point-by-point counter to them. However it is quite amazing that these points have gone relatively unnoticed by bears over all these years, and anyone who has done their homework properly should have observed them long ago. This suggests to me the presence of a group-think mentality in the bear camp.
But group-think or no group-think, I am persistent in my belief that we are in a multi-decade secular bear market which should see the 20-year T-bill outperform stocks on a risk-adjusted basis. Longer term, the better investment opportunities are to be found in Asia and in emerging markets, with special focus on economies like India, Malaysia, Thailand and the Philippines. Investors should also presently overweight European and Asian debt instruments of higher grade and shorter duration, and switch again into emerging market debt only after the next recession has played itself out.
In the short run, the US market is reaching an overbought level and intermediate-term indicators have either already peaked out or are showing definite signs of peaking out. However, sentiment is still not excessively bullish even though we are right now inching towards that direction, day by day. (Remember that sentiment indicators are contrarian indicators, so we interprete a bullish sentiment reading as actually being bearish for the market, and vice-versa.) As such if we begin to decline from here, it would not be a severe decline. On the other hand, a good rally that sends the short and medium-term indicators to maximum overbought levels and which also sends sentiment to excessively bullish levels would represent a terrific shorting opportunity. My technical update will spell out the situation in greater detail.
TRADING STRATEGY: Remain neutral until further developments. Short the market on excessive bullishness, in particular, if the S&P re-captures 1140 and sends the 10-day moving average of the CBOE put/call ratio below 0.80.
INVESTMENT STRATEGY: Overweight bonds and underweight stocks in general. Within bonds, overweight short duration investment-grade bonds. Within stocks, overweight Asia. Be prepared to change to 100% bonds upon signal of the next recession (due 2005-2006).
Tuesday, October 05, 2004
Technical updated dated 4 Oct, 1000am.
As you probably know, the S&P rallied to a swing high of 1131 on Friday, catching almost everyone (including yours truly) by complete surprise. I was certainly not positioned to capitalize on this move, to my utmost regret.
In a market as confusing and frustrating as this one, it sometimes helps to go over past analysis and reflect upon the situation from a few different angles.
Two weeks ago, I opined that the intermediate-term indicators are rapidly heading towards overbought levels, suggesting that the rally in the US markets may end going into end September and early October. As of now, the 30-day moving average of the advance-decline (A/D) line as well as the McClellan Summation Index based on volume are indeed overbought, but not necessarily maximum overbought. This suggests that it is late in the rally, although there may be some upside left.
The sentiment front, however, is a bit less straightforward. Folks have never really embraced the recent rally in a major way. Indeed, the 10-day moving average of the CBOE put/call ratio stubbonly still remains at a neutral level despite the good showing by the markets. Remember that sentiment indicators are contrarian indicators, so a bullish reading is interpreted in the contrarian sense as being bearish for the market.
The percentage of bulls and bears recorded in the Investor's Intelligence weekly survey, while in bullish territory, is still not excessively bullish. Again we have a mixed result. So long as sentiment is not excessively bullish, we cannot decline in any major way.
Short-term indicators were oversold early last week after the temporary pullback, after the Real Distribution Day recorded on Sept 22 (which flushed out our stop-loss, if you can recall) and the persistent downside action thereafter. But the 3-day rally last week pushed them up again and they might become overbought going into next week.
If the markets continue to rally strongly, especially if the S&P flushes out the bears at 1140, it is entirely conceivable that this may tip the sentiment scales into excessively bullish territory. Coinciding with maximum overbought readings on BOTH short-term as well as intermediate-term indicators, this would then set the stage for the next leg down. Hence on the indicator and sentiment front, it would make sense to hold long positions for now and reverse them to short positions only after the market has rallied further and converted the remaining bears to bulls. For those holding no positions however (such as yours truly), my opinion is to buy on any pullback BEFORE thursday.
Let us now analyse the market from a cyclical/seasonal perspective. A few weeks back before this rally started, I opined that the US markets have so far been unable to capitalize on a bullish election-year template by rallying to new swing or yearly highs. The recent market action has changed this scenario to some degree. Indeed, the market now appears to be catching on to the election momentum, and there is still a chance for a strong showing ahead of the polls.
Remember that if the market is internally strong, overbought conditions in the market need not be worked by a severe pullback, but can also be worked off by an extended sideways consolidation phase, such as what we witnessed in July-Sept 2003. Indeed, if a serious decline does not occur between now and the election, it would be a sign of internal strength in the markets.
On the other hand, if a selloff should occur before the election with the market finding a low rapidly in price and time, then there is a good chance of the market clawing its way back up during and after the election period to new swing highs. The only uncomfortable thing I have about this scenario is that the concept of a post-election rally is too widely embraced (and you know how I feel when something is too widely believed).
Seasonally speaking, the month of October frequently records swing lows --- the only question is from what level? From S&P 1100 or from S&P 1140? It makes a world of difference.
Will we find a low rapidly in price and time in October before swinging up to grab the bear's coats at S&P 1140, or will we rally to suffocate the bears at S&P 1140 before swinging down decisively and giving the second mouse (or rather, the second bear) the cheese?
I seriously do not know which one will occur, although the sentiment and indicator analysis makes me lean towards the latter situation (rally then decline). In terms of price action, I would of course much prefer the former situation (decline then rally) --- it would be best if the S&P turns its monthly chart down in October on trade below 1101.29, rapidly find a low in price and time, and in so doing, carve out a good risk/reward trade setup for a swing to S&P 1140. But alas, you know the market rarely accomodates.
The S&P is at an important inflection point. On one hand, the S&P on the weekly chart has carved out a bullish 1-2-3 Swing-to-a-Test off the Aug 13 swing low of 1060, and in so doing, positioned itself for an Angular Rule-of-Four breakout over the 3-point declining trendline defined by the April, May and July highs.
On the other hand, it was beaten back on Sept 22 by a Real Distribution Day and subsequent pattern-failure, which suggests the 3 lower highs on the weekly chart has successfully defined a multi-month market top and suggests even more downside action ahead. To the market's credit however, last Friday's Real Accumulation Day on both the S&P and NASDAQ has offset Sept 22's RDD.
To recapitulate, the market rallied for 6 full weeks, got beaten back somewhat, and now is rebounding strongly again, with an RAD offsetting an RDD. Indeed, the nature of price action is to thrust, pause, and then pivot again in the direction of the original thrust. Such is the nature of volatility --- to contract and then expand.
The late January to mid August slow market decline may simply be a consolidation phase to work off the fantastic March 2003-Jan 2004 rally. Only time will tell. For now, I would bet that the market will continue thrusting upwards in genuflection of the bullish 1-2-3 Swing-to-a-Test as well as the election-year setup, and then just when everyone is overconfident and overexuberant again, the market will start to work off the next leg down --- to everyone's surprise yet again.
As you probably know, the S&P rallied to a swing high of 1131 on Friday, catching almost everyone (including yours truly) by complete surprise. I was certainly not positioned to capitalize on this move, to my utmost regret.
In a market as confusing and frustrating as this one, it sometimes helps to go over past analysis and reflect upon the situation from a few different angles.
Two weeks ago, I opined that the intermediate-term indicators are rapidly heading towards overbought levels, suggesting that the rally in the US markets may end going into end September and early October. As of now, the 30-day moving average of the advance-decline (A/D) line as well as the McClellan Summation Index based on volume are indeed overbought, but not necessarily maximum overbought. This suggests that it is late in the rally, although there may be some upside left.
The sentiment front, however, is a bit less straightforward. Folks have never really embraced the recent rally in a major way. Indeed, the 10-day moving average of the CBOE put/call ratio stubbonly still remains at a neutral level despite the good showing by the markets. Remember that sentiment indicators are contrarian indicators, so a bullish reading is interpreted in the contrarian sense as being bearish for the market.
The percentage of bulls and bears recorded in the Investor's Intelligence weekly survey, while in bullish territory, is still not excessively bullish. Again we have a mixed result. So long as sentiment is not excessively bullish, we cannot decline in any major way.
Short-term indicators were oversold early last week after the temporary pullback, after the Real Distribution Day recorded on Sept 22 (which flushed out our stop-loss, if you can recall) and the persistent downside action thereafter. But the 3-day rally last week pushed them up again and they might become overbought going into next week.
If the markets continue to rally strongly, especially if the S&P flushes out the bears at 1140, it is entirely conceivable that this may tip the sentiment scales into excessively bullish territory. Coinciding with maximum overbought readings on BOTH short-term as well as intermediate-term indicators, this would then set the stage for the next leg down. Hence on the indicator and sentiment front, it would make sense to hold long positions for now and reverse them to short positions only after the market has rallied further and converted the remaining bears to bulls. For those holding no positions however (such as yours truly), my opinion is to buy on any pullback BEFORE thursday.
Let us now analyse the market from a cyclical/seasonal perspective. A few weeks back before this rally started, I opined that the US markets have so far been unable to capitalize on a bullish election-year template by rallying to new swing or yearly highs. The recent market action has changed this scenario to some degree. Indeed, the market now appears to be catching on to the election momentum, and there is still a chance for a strong showing ahead of the polls.
Remember that if the market is internally strong, overbought conditions in the market need not be worked by a severe pullback, but can also be worked off by an extended sideways consolidation phase, such as what we witnessed in July-Sept 2003. Indeed, if a serious decline does not occur between now and the election, it would be a sign of internal strength in the markets.
On the other hand, if a selloff should occur before the election with the market finding a low rapidly in price and time, then there is a good chance of the market clawing its way back up during and after the election period to new swing highs. The only uncomfortable thing I have about this scenario is that the concept of a post-election rally is too widely embraced (and you know how I feel when something is too widely believed).
Seasonally speaking, the month of October frequently records swing lows --- the only question is from what level? From S&P 1100 or from S&P 1140? It makes a world of difference.
Will we find a low rapidly in price and time in October before swinging up to grab the bear's coats at S&P 1140, or will we rally to suffocate the bears at S&P 1140 before swinging down decisively and giving the second mouse (or rather, the second bear) the cheese?
I seriously do not know which one will occur, although the sentiment and indicator analysis makes me lean towards the latter situation (rally then decline). In terms of price action, I would of course much prefer the former situation (decline then rally) --- it would be best if the S&P turns its monthly chart down in October on trade below 1101.29, rapidly find a low in price and time, and in so doing, carve out a good risk/reward trade setup for a swing to S&P 1140. But alas, you know the market rarely accomodates.
The S&P is at an important inflection point. On one hand, the S&P on the weekly chart has carved out a bullish 1-2-3 Swing-to-a-Test off the Aug 13 swing low of 1060, and in so doing, positioned itself for an Angular Rule-of-Four breakout over the 3-point declining trendline defined by the April, May and July highs.
On the other hand, it was beaten back on Sept 22 by a Real Distribution Day and subsequent pattern-failure, which suggests the 3 lower highs on the weekly chart has successfully defined a multi-month market top and suggests even more downside action ahead. To the market's credit however, last Friday's Real Accumulation Day on both the S&P and NASDAQ has offset Sept 22's RDD.
To recapitulate, the market rallied for 6 full weeks, got beaten back somewhat, and now is rebounding strongly again, with an RAD offsetting an RDD. Indeed, the nature of price action is to thrust, pause, and then pivot again in the direction of the original thrust. Such is the nature of volatility --- to contract and then expand.
The late January to mid August slow market decline may simply be a consolidation phase to work off the fantastic March 2003-Jan 2004 rally. Only time will tell. For now, I would bet that the market will continue thrusting upwards in genuflection of the bullish 1-2-3 Swing-to-a-Test as well as the election-year setup, and then just when everyone is overconfident and overexuberant again, the market will start to work off the next leg down --- to everyone's surprise yet again.
